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July 1, 2013

Behavioral Finance in the Real World: Fund Profits From Human Bias

OBIOX has returned 20.88% year to date by identifying companies overlooked by market bias and taking advantage of earnings surprises

Oberweis International Opportunities Fund (OBIOX) portfolio manager Ralf Scherschmidt is such a big fan of behavioral economist Dan Ariely that he and his team reread the Duke University professor’s best-selling book at least once a quarter.

Ariely’s book, Predictably Irrational: The Hidden Forces That Shape Our Decisions, serves as the inspiration behind the Chicago area-based Oberweis team’s investment strategy, which has resulted in a 20.88% year-to-date total return on OBIOX. The Oberweis fund is the No. 1-ranked fund in the foreign small/mid growth category, according to Morningstar. No. 2-ranked Oppenheimer International Small Co A has seen a 13.69% year-to-date total return as of Monday.

With that behavioral finance knowledge in hand, the OBIOX team identifies small-cap companies in the developed world that are overlooked by market bias and then takes advantage of earnings surprises. When a company’s fundamentals improve significantly and result in earnings that surprise the market, investors often struggle to immediately accept the change because they are biased by their previous estimates.

‘The Initial Human Reaction Is to Resist a Change in Belief’

“If the market did understand the underlying fundamentals, there wouldn’t be a surprise in the first place,” said the 37-year-old Scherschmidt (left) in an interview on Friday, noting that market players are human beings subject to inherent biases. “It takes the market a long time to incorporate new information into stock prices. People’s original belief about a business gets proven wrong, but the initial human reaction is to resist a change in belief. That’s what we can take advantage of.”

Scherschmidt, who launched OBIOX on Feb. 1, 2007, first learned about the economic theory of behavioral finance as a Harvard MBA student. When working under portfolio manager Joel Dobberpuhl of Jetstream Capital, a Tennessee hedge fund that has since closed, Scherschmidt learned to apply the theory as a stock picker.

To be sure, OBIOX’s stellar performance is due in part to greater market forces. Quantitative Equity Strategies founder Ben Warwick reported in his monthly index report for June that small-cap growth stocks have outperformed all other asset classes year to date, with the Russell 2000 Growth Index posting a 17.4% YTD return.

280% Turnover, 1.6% Expense Ratio

Because the fund’s strategy is based on how long it takes people to change their behavior after seeing they were wrong, the best situations involve a high return in a short time span – but as a result, OBIOX saw a high 280% turnover ratio in 2012, which pushed up the fund’s expense ratio to a relatively high 1.6%.

“We probably have a higher turnover than many of our peers. When we have a turnover, it’s a sign that we have good ideas and they’re working out quickly,” Scherschmidt said. He added that year to date in 2013, the ratio is closer to 90% to 100%, and that last year’s 280% was atypical.

Assets under management for OBIOX total about $50 million on the retail side and about $150 million on the institutional side.

Scherschmidt and team try to identify companies where the current market consensus for that company’s future earnings and future cash flow are incorrect. They seek to buy into companies that earn more than current consensus expects.

For example, with Duerr, a German auto parts manufacturer, the OBIOX team’s initial investment thesis in 2010 was for a consensus estimate that Duerr would earn 2.22 euros in 2012. A couple of months ago, Duerr reported 2012 earnings of 6.20 euros per share.

“Those are the kinds of situations we look for,” Scherschmidt said. “People figure out slowly over time that earnings are better than expected. We’ll hold on to Duerr until the rest of the investment community realizes what the company will truly earn. We still hold Duerr today because the market’s future forecasts are still wrong.”

Asked how he and his team resist their own behavioral biases, Scherschmidt answered: “Ah! One of my favorite questions. I and my team are human, and we can fall into the same traps. So once a quarter, we reread Ariely’s book, and on a day-to-day basis, when a team member makes a stock recommendation, one of the other team members plays devil’s advocate. We’re always challenging each other. We have fun at the job. My colleagues challenge me, too, and it’s always fun to challenge the boss.”

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